7 Expectations of Real Estate Investors – Beware of Potential

BawldGuy Axiom: Expectations are sometimes akin to potential — a blessing and a curse — both dressed up like the prom queen.

How many times have we seen college sports superstars with a world of potential fall flat on their faces in the pros, dashing the expectations thrust upon them? In baseball it’s even worse sometimes, as high school phenoms sign for a few million bucks only to disappear in the land of shoulda coulda woulda.

In real estate investing, the potential for building a solid retirement is very real. Countless people have done it — you may be in one stage or another as you read this. Expectations generated from potential, no matter how well researched, are the foundation for much of the disappointment felt down the road by investors. This is a direct result of embedding potential into analysis — a definite no-no.

There’s a huge difference between reasonably prudent expectation, and the potential for something to materialize, that’s completely out of our control.

Appreciation used to be an acceptable factor for the investor to use in their decision making process — at least for the period beginning in the late ’60s early ’70s, ’till this latest Mother of All Corrections. Even so, I’m so dang OldSchool that my long term cash flow analyses would include 5% annual increases in value at most (often less) — in the midst of whatever boom cycle we were in at the time. Even clients would raise eyebrows at me, wondering why so little. Even then, I’d attach mind numbing caveats clearly stating appreciation comes and goes, seemingly of its own volition. Nobody ever gets upset when a property appreciates more than they expected. So when you enter into an investment without any prediction of values rising, a little appreciation can be exciting.

Same goes with future rent increases, or the other side of the coin, operating expenses. Sure, a brand new property will blithely sail along for a few years with little if any maintenance, but after five years at most, checks will be written — ones with your signature.

Here are some things you can usually, not always, prudently expect.

1. Cash Flow ‘Course just cuz it spits out cash flow from Day 1 doesn’t mean it will in year three. Ya think your crystal ball is any less cracked than the rest of ours? Not freakin’ likely.

2. Your Loan Balance Will Decrease Yes, and count on this one — as long as your loan is amortized. In about five years a $200,000 loan at today’s rates will have a balance an inch less than $185,000.

BawldBarBet: Though simple logic says doubling the payment on a 30 year loan will pay it off in 15 years, that logic is erroneous. Fact is, if you increase your payment by just 44% your loan will be erased in half the time. Think reverse compounding. In other words, by adding $500 to your monthly payment on a $200,000 loan — you’re done in half the time. (30 year pmt = $1,135.58 and 15 year payment = $1,634.17 — at 5.5%)

3. Tax Shelter — Depreciation Barring changes in tax law, (Yeah, THAT never happens.) expect your cash flow to be completely sheltered by depreciation, unless you put so much down, (Or paid cash?) that the cash flow overwhelms it. These days 20-30% down payments will generate 100% tax sheltered cash flow for around 3-5 years. It could be more or less depending upon what supply/demand does with rents. Duh.

4. If you and/or you and your spouse earn $150,000/yr or more at work, DO NOT count on any tax shelter for that income. You’re considered ‘rich’, so once you hit $100,000 they begin takin’ it away ’till ya hit the $150,000 mark. At that point your depreciation will shelter your cash flow only. Except, that is, ’till it comes time to maybe offset some capital gain in the future.

Note: Unused depreciation doesn’t evaporate under normal circumstances. In fact, we incorporate that little golden factoid into many of our clients’ Purposeful Plans. But that’s a separate post by itself.

5. Murphy WILL Visit You This one ain’t potential — expect it. Sooner or later it will be your turn in his special barrel, one way or t’other. To think otherwise is folly.

6. Expect To Fund a Sominex Account (Ambien?) Those who invest in real estate without generous cash reserves simply don’t understand #5. You want the ‘potential’ to turn small problems into big ones? Don’t have abundantly funded cash reserves. Ever heard O’Toole’s Corollary to Murphy’s Law? “Murphy was an optimist.” ‘Nuff said.

7. Expect the Need to Be Flexible I’ve likened Purposeful Plans to giant trees. Incredibly strong in their ability to weather the elements, but flexible when necessary. A tree that can’t bend with the wind will, sooner or later, snap. Your Plan must be adaptable to changes in the economic landscape.

Are there more than seven? Yeah, but these seem to be the ones most frequently abused. Potential often comes disguised as a prom queen. You’ll be OK as long as you understand there simply aren’t that many prom queens floatin’ around.

Gimme a call at 619 889-7100 — I need a fix. Have a good one.

Related posts:

1. Real Estate Investors — Is Your Addiction To Cash Flow Lowering Potential Retirement Income?
2. Tax Shelter — Real Estate Investors Should Beware the Professional Investor Trap
3. How Real Estate Investors Get It Done – Tax Strategy
4. Real Estate Investors – Don’t Be Seduced By Rickety Cash Flow
5. Real Estate Investors — Beware A Deadly Virus — Subjectivity